MODERN PORTFOLIO THEORY -Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.! MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways., to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets returns are not negatively correlated—indeed, even if they are positively correlated.! More technically, MPT models an assets return as a normally distributed function , defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient.! MPT was developed in the and was considered an important advance in the mathematical modeling of finance. Since then, some theoretical and practical criticisms have been leveled against it. These include evidence that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events . ! Further, there remains evidence that investors are not rational and markets may not be efficient. Finally, the low volatility anomaly conflicts with CAPMs trade-off assumption of higher risk for higher return. It states that a portfolio consisting of low volatility equities (like blue chip stocks) reaps higher risk-adjusted returns than a portfolio with high volatility equities . A study conducted by Myron School es, suggests that the relationship between return and beta might be flat or even negatively correlated.! CONCEPT - The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on its own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.! Investing is a trade off between risk and expected return. In general, assets with higher expected returns are riskier. The stocks in an efficient portfolio is chosen depending on the investors risk tolerance, an efficient portfolio is said to be having a combination of at least two stocks above the minimum variance portfolio. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.! HAVE A NICE DAY ,,,,,,,,,,,,,,,,,,,,,,,,,,,, FRIENDS !
Posted on: Sat, 27 Dec 2014 13:29:05 +0000
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